Analyst Insight: Affirm Holdings Second Look
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After a bizarre Twitter accident or a legitimate attempt at financial theater, Affirm Holdings was absolutely clobbered by investors on Friday. Sentiment surrounding the Buy Now Pay Later (BNPL) heavyweight initially seemed positive when leaked preliminary results indicated strong growth in total transactions, gross merchandise volume, and revenue. However, what wasn’t included in the now-deleted tweet was Affirm’s dramatically widening net loss, disappointing guidance, and a shift in revenue mix. Together, these were enough to scare the market, which sent the stock tumbling more than 30%.
We first took a look at Affirm during its IPO in February of 2021 so now seems like a great time to check back in. Especially, if the business is going through a period of reconfiguration that may impact its long-term prospects.
The Nitty Gritty
Firstly, it’s important to remember how Affirm makes money. As a Buy Now Pay Later player, it helps consumers access financing and payment plans when shopping at one of its many retail partners. Like a traditional lending operator, this means Affirm generates revenue from interest payments. Unlike some of its BNPL competitors, it does not charge late fees for missed payments as Affirm believes its detailed modeling of consumer behavior makes it more apt at estimating creditworthiness.
It created a proprietary scoring system called ITAC that grades potential buyers on a scale from 1 to 100, 100 being the best. While it uses credit scores, its analysis is not limited to them, allowing more customers to access its tools.
That being said, one of the greatest appeals of BNPL services to consumers is more often than not, they receive 0% APR. For this reason, Affirm also charges merchants a fee. Merchants are happy to comply because BNPL services have been proven to raise average basket size and lessen consumer hesitation. In most quarters of the past, merchant fees have accounted for more than 50% of Affirm’s overall revenue, with interest and loan sales making up the rest.
Affirm’s merchant fees vary and are determined by the interest rate and length of the lending period. Affirm calls these products: Core 0% Long, Core 0% Short, Core IB, and Split Pay. Core 0% Long includes loans with term lengths greater than 12 months and no interest, they carry a merchant fee of more than 12.5%. This is more than double the rate of any other Affirm product.
For the entirety of the pandemic and quarantine, Core 0% Long was Affirm’s bread and butter.
Why, you may ask?
Because at the time, Affirm’s largest merchant partner was Peloton. For months, the exercise equipment company advertised its 36-month financing, which brought its starter bike under $50 a month. For every bike Peloton sold via financing, Affirm took a 12.5% cut.
When Affirm IPO’d last year, sales of Peloton equipment accounted for more than 25% of its revenue.
From Affirm’s latest quarterly report.
The Good, the Bad, and the Ugly
Luckily, since then, Affirm has diversified its revenue stream and seen growth in other key ways.
In its latest quarter, it had 168,000 active merchants, an impressive jump from a year ago when it only had 8,000. Much of this expansion can be credited to the service’s lucrative partnership with Shopify which grants millions of e-commerce retailers easy access to BNPL integration.
At the same time, active consumers jumped by 150% while transactions per active consumer increased by 15% year-over-year. This tells me Affirm has the best of both worlds, new customers are coming through the top of the acquisition funnel while existing customers are being retained and encouraged to shop again. This is a reflection of Affirm’s merchant penetration across in-demand shopping sectors but also its recent push into consumer-facing services. We’ll talk more about these later on.
All the while, revenue increased by 77% year-over-year, while gross merchandise volume (GMV) jumped 115%. Both metrics look good and scream growth but the difference between them is worth noting. When compared, revenue as a percentage of GMV is beginning to fall, meaning Affirm’s revenue generation is becoming less efficient.
You could assume this is caused by merchant fee rates decreasing but that’s not the case. Fee rates have remained largely unchanged since 2020. Instead, it would appear, Affirm’s product mix is shifting and more and more merchants are using its lower fee options.
This thesis is supported when you look at the company’s revenue breakdown. Last quarter, merchant fees only made up 35% of total revenue, down from 49% a year ago.
This Town Ain’t Big Enough for the Both of Us
While a partnership with Shopify would ordinarily be the highlight of 2021 for a company like Affirm, this instance was outshined by huge agreements with both Amazon and Walmart. In September, Walmart replaced its legendary in-store and online layaway service with Affirm just in time for the holiday season. Two months later, Affirm was confirmed as the exclusive BNPL provider for Bezos’ king of e-commerce in the United States until 2023, a title it achieved after an initial trial period.
But, alliances of this size don’t come without a few caveats.
Affirm is used to having the power in its merchant relationships. It provides an essential service for many retailers specializing in big-ticket items. Undoubtedly, the success of Peloton during the pandemic could not have been achieved without such easy-to-access customer financing. Hence, why Affirm is able to justify such a hefty merchant fee.
But in the case of Amazon and Walmart, there is far less pressure to provide a BNPL service as consumers shop there for any number of things, big or small, expensive or cheap. Amazon will continue to generate revenue whether it has a BNPL service or not, Affirm is really the cherry on top of an already decadent sundae.
For this reason, these titans of commerce are far less likely to accept hefty merchant fees. Not to mention, their considerable negotiating power thanks to their substantial merchandise volume. In Affirm’s most recent report, Amazon already accounted for 7% of total GMV. This is even more stunning when you remember Affirm’s services only became available to most Amazon shoppers in the middle of November. Meaning, most of that merchandise volume was generated in a mere six weeks.
It would appear, Amazon and Walmart would prefer that the onus for BNPL services not fall on them but consumers as both have opted for Affirm’s Core IB product. Core IB represents loans with short terms and interest, it also happens to have the lowest merchant fee rate.
If Affirm continues to migrate towards behemoths with low take rates, it will generate less revenue upfront, and revenue as a percentage of GMV will continue to fall. However, that doesn’t mean this revenue is lost entirely.
It is possible it will be made up for down the line as consumers make payments with interest. Unlike merchant fees which are recognized at the time of the sale, interest is recognized ratably over the life of the loan, so we’ll see it gradually trickle through over the coming quarters.
Affirm’s pivot towards interest-bearing products was rather sudden, it seems to have taken place over the course of the last six months. This explains the disparity between revenue and GMV and the market’s rather negative reaction. Analysts and investors were used to seeing growth that looked like a jagged staircase, jumping from quarter to quarter. A reliance on interest-bearing products will smooth and slow this growth rate as more and more revenue is deferred.
This may explain the company’s revised guidance. Its revenue outlook for next quarter is expected to be between $325 million to $335 million, a slight correction from a previous estimate of $334.8 million.
Welcome Everybody to the Wild Wild West
When we take all these factors into account, does it make the selloff of Affirm’s stock an overreaction? That’s still up for debate.
Investors were also caught off guard by a substantial operating loss of $196.2 million, compared to a loss of $26.8 million a year earlier. Much of this can be attributed to an $82 million increase in stock-based compensation following Affirms IPO and significant investment in hiring and marketing. Affirm is still very much in the ramping-up period and will undoubtedly burn through more cash as it attempts to dominate this highly competitive field. Who knows when the company will edge towards profitability?
Speaking of competition, that remains plentiful and is still a huge concern for the company’s long-term prospectus. In the face of merchants demanding lower fees, Affirm has doubled down on its consumer-facing product known as a non-integrated virtual card. Shoppers make an account and generate a single-use payment card to avail of Affirm’s payment plans in retailers that might not be partnered with them. In its latest quarter, Affirm saw revenue from this product more than double.
However, the downside of moving into a direct-to-consumer model is it pulls Affirm into competition with larger, more well-known players. The most threatening of these would be Apple, which plans to launch a BNPL service integrated with Apple Pay. Arguably, this has a higher likelihood of penetrating the consumer market as it will be consolidated with a service millions already know and consistently use. There will be no need to create an extra account, BNPL will just be an added bonus rather than the central focus of the product.
We also haven’t seen the wider impacts of a lending market dominated by BNPL players. Issues like regulatory scrutiny or widespread economic distress have yet to properly test Affirm, which only launched its service in 2018.
Recent quarterly reports have shown that Affirm is approving more and more loan applications for less qualified individuals and delinquency rates have risen in 2022. If we are heading into a period of economic uncertainty, Affirm will have to protect itself and spend even more on provision for credit losses, taking another bite out of profitability. In its most recent quarter, spending of this kind more than quadrupled.
As a side note, from an analyst or investor perspective, it is very difficult to assess the profile of most of Affirm’s customers as it uses its own internal evaluation system known as the ITAC. No equivalency metric is provided so those of us outside the fold can’t easily understand the risk each cohort possesses.
As the usage of BNPL services has increased, so too have instances of insolvencies and missed payments, raising concerns over their ability to judge loan recipients. In Australia, BNPL funding is a factor in one out of five consumer bankruptcies. In America, two-thirds of BNPL users have a credit card balance that's 75% of their limit or more when making their first BNPL purchase, making them a substandard candidate for a loan.
Off into the Sunset?
Affirm is winning in a lot of ways, it has a plethora of retail partners, increasing customer retention, and staggering revenue growth. But, what struck me most about this quarter was how much it revealed about the uncertainty that remains in the BNPL space.
Affirm had early success with merchant fees but now it's pivoting towards interest-bearing products, making it little more than an easy-to-access credit card. I worry this will draw even more regulatory scrutiny and competition. Not to mention, a change in the average customer’s credit history opens the company up to a mass default should economic conditions substantially worsen.
For now, I will be observing Affirm from the sidelines, eager to see how its changing revenue mix will impact the future.